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Let the Market Dictate Strategy

Let the Market Dictate Strategy

Options are a versatile tool. And, they can be a confusing tool. Versatility means that with options, you can profit whether a stock moves up or down or stays in a relatively narrow trading range. There are dozens of possible strategies and investors can become confused about which one to use.

To avoid the confusion, some investors simply take directional trades with options. They will buy a call if they believe the stock is going up or they will sell a put if they believe a stock is likely to go down. This strategy can be profitable, but it is not taking advantage of the potential options can provide.

Options prices are determined by factors besides the price of the underlying stock. Among the most important factors in options pricing formulas is the volatility of the underlying stock. Volatility is a measure of a stock’s average movement. When a stock is trading within a relatively narrow range, volatility is low.

Since volatility is a factor in options pricing, it can be useful to consider volatility when selecting trades.

A Simple Measure of Volatility

There are a number of indicators designed to measure volatility. They range from complex formulas to relatively simple tools. Among the simplest, and most readily available, is the average true range (ATR). This indicator can be found at a number of free web sites.

The ATR is one of several useful indicators explained by J. Welles Wilder in his classic book, “New Concepts in Technical Trading Systems.” This book also introduced RSI and several directional trading systems.

ATR is based on the true range (TR). TR is defined as the largest value of the day’s trading range (the high minus the low); or the absolute value of the current high less the previous close or the absolute value of the current low less the previous close. The TR recognizes the fact that gaps represent a high level of volatility. The traditional range calculation ignores gaps.

The ATR is simply a moving average of the TR. The default value is 14 but other time frames can be used.

Interpreting ATR is a straightforward process. High levels of ATR are associated with high volatility and low readings of the indicator are seen when volatility is low.

The chart below shows the ATR for Zimmer Biomet Holdings, Inc. (NYSE: ZBH). This chart is made with the free tools available at TradingView.com. That web site allows users to change the parameters of indicators and this chart shows a 10-week ATR.

This chart illustrates how ATR moves up as volatility increases and down as volatility declines. ATR is calculated with absolute values which ignore sign. Therefore, ATR is always positive and the price trend is not shown with the ATR. This indicator only measures volatility.

Linking Volatility to the Trend

While volatility and the direction are technically independent of each other, they do move in a correlated manner most of the time. The two sets of data will usually be inversely correlated. When volatility is declining, prices are usually moving higher. Increasing volatility is associated with price gains.

This relationship is well known and the reason the popular VIX index is known as the “fear gauge.” Traders believe when VIX rises, fear is rising and this is seen when prices are falling. Likewise, traders tend to see low levels of VIX when prices are rising and the level of fear is low in the stock market.

Understanding this, we can develop a strategy for trading options. Looking at the chart of ZBH again, the ATR is falling as prices rise on the left hand side of the chart. The trend levels off, and prices consolidate as the ATR declines towards the center of the chart. Recently, ATR has been declining.

The implications of all this for ZBH are that, based solely on the ATR indicator, the price of the stock is likely to rise as ATR declines.

Using ATR to Spot Options Trading Opportunities

While options are versatile, let’s focus on simple strategies to study ZBH. The fact that ATR is bullish points towards the possibility of buying a call.

But, as you remember, volatility is one of the most important factors in options pricing. As volatility declines, which would be shown as a decline in the ATR, the price of the options should decline. In other words, high volatility is likely to be associated with high options premiums.

Buying an option when the premium is high means paying a great deal for the potential gains. As the options premium declines, reflecting a decrease in volatility, the buyer of the option sees their potential profits fall. This is true even if they are correct in their assumption about the direction of the trend.

To benefit from declining volatility, traders can sell options. This allows them to collect the high premium from the price of the option and benefit from the decline in volatility because the decline in volatility will result in a decline of the option’s premium, assuming the trend favors the position.

For options traders, buying a call is equivalent to selling a put option. This is true because both strategies benefit if the price of the underlying stock increases. High volatility, therefore, hurts call buyers, in effect, while it benefits put sellers.

ATR can be used to determine whether it is better to buy or sell an option.

When volatility is low, the ideal time to buy an option could be as it begins to rise. This can be spotted using ATR. A trend reversal in the ATR could be a signal to open an options trade. In a similar manner, the decision to sell an option can include requiring the ATR to be turning down.

Other volatility indicators besides the ATR could be used. Bollinger Bandwidth is one indicator that could work. The VIX index itself could be used as a proxy for overall volatility, although indicators specific to the stock will highlight more specific trading opportunities.

A Specific Trade Example

Turning our attention back to ZBH again, we see that the stock is in a pullback. The declining volatility indicates the pullback most likely presents a buying opportunity in the stock. We could buy a call, sell a put or use a variety of other options strategies. To keep it simple, we will limit the choice to two strategies.

Buying a call will be expensive. An at the money call expiring on August 18 will cost about 2% of the stock price. This requires a gain of 2% before the trade can be profitable at expiration.

Selling a put could be a less costly, and higher probability way to profit from the expected trend.

A put option expiring on August 18 with an exercise price of $120 is trading at about $0.55. Selling the options generates immediate income of $55 since each contract covers 100 shares. This trade is profitable unless ZBH declines by more than 4% in the next three weeks.

Brokers generally require trading capital of about 20% of the exercise price to sell a put. The exact amount varies and is usually a little below that amount. This means selling the ZBH put will require $2,400 in trading capital.

The return on required capital is about 2.2%, a significant gain for less than three weeks. Repeatedly selling puts could generate large returns for small investors who patiently put volatility to work for their benefit.